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Why I Don’t Trust This Rally

August 15, 2011 — Sam H. Fawaz

We finally strung together three up days in a row in the stock markets today and that’s a good thing. Volatility is ratcheting down and folks are stepping in to scoop up bargains. Unfortunately, for the first time since we bottomed back in March 2009, I don’t trust this rally and believe that we are headed back to test last week’s low of 1,101 on the S&P 500 index in the short term. If the market doesn’t hold at that level, our next stop is likely 1060. Let me explain why this rally has a lot to prove before I believe that this correction is over:

1. Other than relieving an oversold condition, not much has changed fundamentally between last week and today. Uncertainties are abound about the possibility of a recession starting or already started (which I don’t believe), how we’re going to deal with raging federal deficits, and the Eurozone debt crisis. A meeting between German and French officials tomorrow will shed some light on how they will deal with the debt crisis in Europe.
2. The three day rally that began last Thursday has occurred on light volume, reflecting very little institutional participation. Institutions often wait for retail investors to bid up the market after a severe selloff to set it up for more selling. The selling has been coming in on very heavy volume while buying is coming in on light volume, a bearish sign.
3. Consumer confidence, as measured by the University of Michigan survey released last Friday, was at a record low. These levels have not been seen since the great recession (but do reflect the recent anxiety over the recent U.S. debt ceiling debacle and stock market sell-off last week).
4. The main stock market sentiment indicators showed an increase in bullish sentiment last week. This is considered a “contra” indicator. After the recent stock market beating, there seems to be more complacency than fear in the markets. Folks are still in “buy the dip” mode. They might have buyer’s remorse if they’re short-term holders.
5. The kind of technical damage to the markets caused by last week’s sell-off takes weeks, if not months, to repair. After-shocks and re-tests of lows are the norm after such a severe sell-off.
The positives that point to a better economic environment and stock market include a better than expected weekly jobs report last week, improved July retail sales figures, good corporate insider buying, and more big corporate mergers announced today.

While I believe that the markets could bounce for a few more days, unfortunately, I feel that we are headed lower over the short-term. The S&P 500 index closed at 1204 today, and we may even climb as high as 1240-1260 before the markets “roll over”. That is 3-4% from here, and it’s only an educated guess on my part since 1250 is approximately where the markets fell apart. I’d like to take advantage of this short-term rise, but only if more volume confirms the move higher. Otherwise, it’s easy to get whip-sawed in this low volume environment.

This is why I continue to hold onto hedges and have refrained from putting available cash to work at this point. I’ve continued to selectively cull positions and rebalance accounts to take advantage of the recent strength in the market. Nonetheless, we remain heavily weighted long in the equity and bond markets despite our cash and hedges. If the S&P 500 index closes above 1290 convincingly, then I’ll re-evaluate my stance, consider pulling in my hedges and invest more cash.

But aren’t we investing for the long term? Why should short-term market dynamics control our investing decisions? While we do invest for the long term, it’s prudent to protect capital when the market is in a well-defined downtrend, especially when a near-term recession is a possibility, albeit a remote one. Markets around the world are factoring in a global slowdown, and the U.S. won’t be immune. Sure central banks may pull a rabbit out of their hat and stimulate the economy and markets once again, and I’ll be ready for that. But for right now, unless I see some institutional “power” behind this rally, I just don’t trust it. As I’ve mentioned before, I expect near-term market weakness until sometime in October.

No part of this message should be considered a recommendation to buy or sell any securities, and you should not act on this without consultation with your financial planner or money manager (better yet, talk to us!) My position will change if the facts change, so I am not married to this position. That could be tomorrow, next week or next month. I don’t have a crystal ball, so my prognostication should not be taken as true fact (I could change my mind or worse, be wrong!)

Please let me know if you have any questions, concerns or feedback. I’d love to hear what you’re thinking.